Fed divulges process behind bank stress tests

According to documents made public today, the assessed banks - which collectively hold two-thirds of the assets and more than half of the loans in the US banking system - submitted their projections of credit losses and revenues over 2009 and 2010 to authorities in early March.

The bank's assessments of their capital adequacy were based on two alternative scenarios for the macroeconomic climate in the US over the next 20 months.

The 'baseline' scenario utilised average projections and consensus forecasts, which assumed a GDP contraction of -2% over 2009 and growth of 2.1% in 2010, US unemployment rates of 8.4% and 8.8%, and house price declines of -14% and -4% over the same period.

The 'alternative more adverse' scenario anticipated GDP falling by -3.3% this year and recovering to only 0.5% in 2010, unemployment hitting 8.9% in 2009 before surging to 10.3% next year, and housing values declining sharply by -22% and -7% over the same period.

Tested firms were asked to estimate potential losses on loans, securities trading positions, off-balance sheet commitments and contingent liabilities over a two-year time horizon. Firms trading over $100 billion in assets were also asked to estimate additional possible trading-related market losses and counterparty credit losses under the adverse scenario based on the market shocks experienced in late 2008.

These submissions were then analysed by supervisors from the Federal Reserve Board, the 12 regional Federal Reserve Banks, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, which evaluated the submitted data and asked certain institutions for additional information to support their conclusions in a process lasting a number of weeks.

Supervisors also applied independent quantitative methods using firm-specific data and evaluated the submissions in the context of previous examination work carried out by regulators. At the end of the process, projected losses, revenues and changes in reserves were combined to calculate the capital levels each bank should have at the end of 2010. Should the economy recover more quickly than the adverse scenario envisages, "firms could take action to reverse their capital build up," the statement said.  

Those firms found to have less capital in reserve than they are projected to need will be required by regulators to take action to boost their capital buffer, through raising private capital through the issue of common shares, the conversion of government preferred shares to common stock, or through additional taxpayer funds.

The Fed release contained no details about the results of the stress tests at any the 19 firms audited, but it is understood that the banks in question were formally notified today whether regulators had signed off on the institutions' assessment of their own capital adequacy or whether they would be required to raise more capital to assuage supervisory concerns. 

Full results of how each bank fared are expected to be released by the Fed on May 4. The SCAP report can be found at: http://www.federalreserve.gov/newsevents/press/.

See also: US stress tests under way
Geithner: US will "force all standardised OTC derivatives into central clearing"
Market frustrated by lack of detail on US toxic-asset purchase plan

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